Despite Tough Talk, Germany Eventually Will Back Down on Greek Debt

by Jeff Reeves | September 12, 2011 9:34 am

After the market mayhem of the last few weeks, it has become clear the sovereign debt crisis across the Atlantic is not going away. It also has become clear that Germany is mightily irritated with the state of affairs, and top European officials are openly discussing the prospect of default for Greece.

The result has been a brutal selloff late last week, some very disturbing losses in Europe this morning and a sharp decline for stocks at Monday’s opening bell to start the week. All told the Dow Jones Industrial average has given up over 5% since its high of around 11,470 on Thursday morning.

However, no matter how panicked the stock market gets and how hawkish German Chancellor Angela Merkel tries to sound, the end result will be another bailout for troubled euro zone nations like Greece. That’s because giving up on the troubled nation would end up costing Germany far more than what it would save in relief funds.

To be sure, the prospect of a Greek collapse is very real. Credit-default swaps (essentially insurance against the country sovereign debt) hit an all-time high of 3,500 basis points before the weekend. A hundred basis points equal 1%, so that’s a premium of 35% on these policies — the highest in the world and more than three times the rate on Portuguese debt. The market clearly believes the default risk is severe — perhaps even likely — with rates like that.

But after two years of grinding it out with Greece and the PIIGS zone (Portugal, Italy, Ireland, Greece and Spain), Germany is too deep into this mess to walk away despite posturing about laying the groundwork for Greek default.

Last week we saw escalating German threats that Greece won’t get the money unless it meets austerity targets, but you can only get so much blood from this stone. And while Merkel and the rest of Europe might be inclined in weaker moments to just wash their hands of this mess, it would send a troubling message to the rest of Europe and to global markets if Greece is allowed to default. Investors will worry that Germany could abandon Portugal — and such fears could make the event a self-fulfilling prophecy as rates soar and credit markets fail to function in Portugal. Then after Greece and Portugal, other nations like Spain could be put on an iceberg and pushed out to sea by global investors.

The dreaded buzzword “contagion” could become a reality. So there’s really no other choice for Germany than to head this mess off and accept the lesser of two evils by bailing out Greece again.

It will be painful for Germany to belly up to the bar and pay for the tab. But the ensuing chaos would be far worse for the euro zone in the long run.

Whether the bailout will do anything to cheer up the market, however, is a much different story. Someone is going to have to pay these debts eventually, and both taxpayers and financial stocks are spread pretty thin right now.